Sunday, December 28, 2014

I. Nominal real estate asset and debt levels are unique and not comparable to other assets.

First I see a problem in the way household debt is frequently described as a sign of middle class stagnation and of a housing "bubble". I have discussed this before. Very short version - most middle class debt is mortgage related. In other words, most middle class debt is related to savings - deferred consumption, not debt-fueled consumption.

The manifestation of many recent market trends is interest rates. With regard to housing, the most important factor is very low long term real rates. Emerging market savers and developed market baby boomers (and their pension managers) have a tremendous demand for long term safe cash flows, so that long term real interest rates have been bid down to very low levels. (Real rates were very low in the 1970's also.) Changing interest rates have different effects on different securities, depending on what is held constant.

1) Treasuries. As treasuries mature and are re-issued, face values are reset. So, coupon payment levels change over time, but the changing asset value of, say, a treasury ETF reverts to a stable mean over time, even if interest rates don't reverse. And, government debt is the product of various political factors that are not related to interest rate levels. So, the quantity of government debt and the market value of that debt do not have a systematic relationship to interest rates. In futures markets that use a stationary bond maturity as the basis, bonds trade based on a premium or a discount to a stationary interest rate, but this is not a factor in the public image of bond values or in the total nominal quantity of bonds over time.

2) Corporate bonds. Corporate bonds have many of the same characteristics as treasuries. It is usually assumed that corporations would sell more bonds when rates are low. I have not found that to be the case. But, even if it were the case, a change of 1% or 2% would only be expected to change corporate debt levels marginally. Corporations don't borrow to target a set interest expense level. They borrow to fund a set nominal investment level.

3) Corporate equities. It is frequently asserted that the stock market is fueled by Fed-induced low rates. Risk premiums for corporate equities tend to move counter to risk free interest rates, so equities also don't react systematically to interest rate changes. Most capital gains in equities come from growth in economic activity and stabilizing aggregate demand during recoveries.

4) Real estate. Real estate is different than all these other categories of assets. The "coupon" on a piece of real estate is the rent. Rent tends to track income, more or less. And, there is no reset on real estate face values - real estate is like a perpetual bond with no maturity reset. So, real estate in the real world, and in our collective consciousness, acts like those bond futures contracts. And since real estate has a very long life, it's nominal value is very sensitive to changes in real interest rates, especially when they are very low. This doesn't only increase the nominal value of real estate assets. Since rents tend to change very slowly, relative to interest rates, this has a similar effect on real estate debt. In a low real long term interest rate context, it can be reasonable to purchase leveraged real estate with very high levels of nominal debt, because the cash flows will compare favorably to renting.

So, when real long term interest rates are very low, like they have been this century, the only nominal asset value they really affect is real estate. I don't have a precise suggestion for adjusting for this fact. But, given that it is a fact, any analysis that uses the changing levels of mortgage debt and real estate values as the signal for some broad social issue is simply baseless. They aren't measuring what they think they are measuring.

But, it's a problem for all of us. I am saying that, if real long term interest rates change over time, the nominal value of assets at a given point in time is not a reliable or useful piece of information. And I don't have a suggested replacement.

This is a difficult condition to accept. But, if you accept the most common story in defiance of my position, then you have to believe that American middle class households have been stumbling under the weight of stagnating incomes and taking on debt to mask the effect on their lifestyles. And this problem has been coincident with an unprecedented and relentless bidding war on owner-occupied middle class housing. That's simply unbelievable, notwithstanding the widespread belief in it.

II. It was not unreasonable to model MBS's based on historical experience.

I come here today to ("gulp", straightens tie nervously) defend David X. Li and the widely derided risk models that were applied to MBS's during the housing boom.

There are many legitimate arguments to be made about assuming normal distributions, continuation of historical trends, etc. These arguments can be made about MBS's as well as many other types of investments. And, to be honest, I am not enough of a statistician to get too far into the weeds on the topic.

But, the point I would like to make is that there is nothing exceptional about MBS's that make the models in use in the 2000's especially bad. The breakdown in the models basically arose from the fact that correlations all rose toward unity. There were admittedly securitizations that, in hindsight, seem to have been made up of especially flimsy mortgages. And, around the margins, we could second-guess some of the ratings that were applied to those securities.

But, in the end, the universal collapse in asset values was a product of Fed policy. My point is that, if you have a self-inflicted black swan - if the Fed is bound and determined to suck liquidity out of the economy - then how can you model that? The only way to be prepared for that is to....I don't know, bury a bunch of gold coins under your porch?

I mean, how'd your house do in 2008? How about your stocks? Even inflation protected bonds dipped in the chaos of late 2008. All these assets fell right along with MBS that had been designed with those models. Nobody needed an actuarial model to lose a substantial sum in 2008. It was a pretty easy thing to do. There were speculators who had the right side of some trades when the bottom fell out. You might have done quite well if you were long volatility. But is there someone out there who had a better risk model, who sailed right through 2008?

Homes lost 30% of their value - in the aggregate - in 2 years. Home prices were stable as interest rates rose. The losses began approximately 1 year after the yield curve inverted, when short and long term rates started to collapse. So, we shouldn't pin responsibility for this on monetary policy? We should blame the MBS models because they weren't robust in the face of 30% aggregate losses and a massive liquidity crisis?

So, can you get caught with your pants down if you own leveraged assets? Of course. Could we have an economy that was based on more robust forms of investment? You bet. Could the Fed give us more stability? Certainly. Our answers to all of those questions matter a lot more than whether or not there were some simplifying assumptions in some asset construction.

I suspect that MBS risk models that are based on historical correlations of defaults - even in MBS with relatively risky mortgages - will perform relatively well in the future. There will be times where they don't perform well. But in those times, it won't be the model that killed you. It will be a war or a pandemic, or a Fed that hasn't accounted for the topic of the first half of this post.

Wednesday, December 24, 2014

since 1890, the average appreciation of inflation-corrected home prices in the United States has been only a third of 1 percent a year. That’s why housing hasn’t been a great investment. And in 10 years, it may be almost equally likely that real home prices will be higher or lower than they are today.

That is kind of a shocking statement to me. That's like saying bonds are a terrible investment because the redemption value will be the same as the initial face value. You don't buy bonds for capital gains. You buy them for income. Likewise, you don't buy a house for capital gains. You buy it for the rent.

Some people do buy bonds or houses as speculative activities, but of course speculation is a zero sum game. That doesn't have anything to do with whether they are good investments. How can Shiller make this statement? The question is, how much does the house cost, how much would rent be (corrected for homeowner expenses), and how does that compare to alternative investments?

In fact, the fact that home prices in the US have roughly tracked inflation suggests that thinking of a home as an inflation-adjusted bond is a pretty good first step for looking at aggregate home values. There is no way that 30 year TIPS bonds are paying a higher return now than the average rental home is. This has nothing to do with what home prices will do in the next 10 years.

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In that column, Shiller also argues against the mortgage tax credit deduction. This is an interesting issue. I agree with Shiller about this. And, I think this would be the perfect time to phase it out. Affordability is not the binding constraint in housing right now. Access to capital is. Households with capital or credit can purchase homes. The homes are underpriced, so for the few that can buy a home with a large mortgage, they are earning excess rents. The mortgage deduction is just adding to those rents. Normally, there would be a fear that ending the mortgage deduction would lead to a drop in home prices that was steep enough to cause an economic dislocation. But, real estate credit has been too hobbled for the mortgage interest deduction to lead to higher prices. Home prices are low enough to be profitable for investors, and at least until very recently, cash buyers have been dominant, so if the mortgage deduction was ended now, cash and institutional investors would keep prices from declining significantly.

But, public housing subsidies are interesting to think about. According to Modern Portfolio Theory, a tradable asset or security that is widely accessible should be bid up to a market price where there are no risk-adjusted excess profits. Optimized portfolios will be diversified, so they will still be exposed to market risk. But any exposure to idiosyncratic risk related to individual securities will not have any excess returns in the aggregate, because that risk can be diversified away.

But, with housing, there is limited access, due to the all-or-none form of ownership that is typical, and there are potential gains from idiosyncratic risk, since such large portions of the market are not, and cannot, be diversified. Also, high transaction costs create a liquidity premium. So it is likely that there are excess returns from home ownership, especially when a home is held for a long period of time, minimizing trading costs.

But, this issue, as is often the case, gets turned on its head. Since home ownership provides excess profits, and these profits tend to go to households with the most access to capital, we tend to think, wouldn't it be fair if everyone could get access to those profits? This is wrong-headed. Profits (accounting for liquidity and idiosyncratic risk) only exist because there is limited access to the market. If everyone gets access, the profit goes away. The solution is to get rid of the profit. But the irony is that, if we get rid of the profit, then moving households into home ownership is not necessarily a benefit. The only equitable outcome for housing policy isn't to subsidize more home owners, it's to make all households indifferent to home ownership.

This is a very difficult distinction for the consensus to accept, because in social policy, we tend to associate middle class behaviors with social improvement, and it is natural to assume that social progress comes from nudging the lower economic classes into that behavior. If middle class behavior involves the accretion of economic rents, universality of middle class behavior is a mathematical impossibility.

A more universal and equitable housing market would come from lower transaction costs, more access to credit, more pathways to ownership, etc. This is a good example of how hard it is to have good public policy in an IMHworld. The housing market of the 2000s was a great example of a context where the housing market was more universal and equitable. Low interest rates, low down payments, investor diversification through securitization - all of these trends were pushing down excess returns in housing and expanding the pool of potential home owners. All great things! In a world where rent payments will be fairly stable, how will lower excess profits (economic rents) be manifest? Through higher asset prices! And, what kind of reputation do the housing market and the financial industry of the 2000s have? Public views of the housing market are definitely an example of strong form IMH.

On all sides of the political spectrum, there seems to be a consensus that the Fed is the lap dog of Wall Street, making sure the financial elite earn economic rents. And there also seems to be a consensus that the era of equity and universality in housing was a monstrosity that had to be beaten down. And the consensus complaint is that the financial intermediaries who made that housing market possible, who for the most part are bankrupt, reorganized, or a fraction of their former selves, have been "bailed out" because the Fed dares to inject some liquidity into the chasm that used to be a credit market.

The mortgage tax deduction really made everything worse. For those who could capture excess profits, the deduction increased those profits. And, on a macro level, it creates a two-tiered market, where there is a general price level for landlords, and a higher price level for owner-occupiers who can benefit from the deduction. This means that supply and demand forces for landlord owners will translate into higher rents. This also means that the market for single family homes, especially homes with higher nominal values, is much thinner than it would normally be. There is a market of non-diversified, owner-occupiers with equilibrium prices above the equilibrium price for landlords. When that market broke down in a context where (1) excess profits had been bid down because of wider credit access and (2) the mortgage deduction continued to provide added profit for owner-occupiers, prices had to fall significantly before landlord investors were willing to add support.

So the mortgage deduction creates a less stable, less equitable market. I wonder what the counterfactual would have been if, during the 2000's, we hadn't had the mortgage interest deduction, but we still had low interest rates, securitization, and all of the other accommodations that came out of low real interest rates, low inflation, and financial innovations. Home prices would have been somewhat lower. Home ownership rates would have been lower. There would have been much broader landlord demand for homes. Rent inflation would have been lower. And, I think that it is plausible that there would have been more supply of homes as a result of all of these factors.

Partly, what was going on in the 2000's was that very low long term real interest rates were pushing up the intrinsic value of homes - the value of homes as an investment. This was pushing up the landlord owner equilibrium price of homes. The equilibrium price for owner-occupiers was naturally above that price, at least partly because of the mortgage deduction. And, low nominal mortgage rates pushed that price even higher, as low monthly payments meant that constraints on demand coming from mortgage credit access were much lower than they had ever been in the modern era. (This is a separate effect from the effect of low rates on the actual nominal value of homes as a durable asset.) But, liquidity issues, transaction costs, the microstructure of the realty market, and the inability for buyers in the owner-occupier market to expand their holdings, meant that there were a lot of frictions and price stickiness in the owner-occupier market. This created the opportunity for a lot of speculative activity. But, it also might have kept supply from rising quickly enough to meet demand, because home builders were generally limited to finding buyers among that thin, friction-filled market of owner-occupiers.

If we hadn't had this two-tiered market, there might have been a more robust market for home builders to build for the renting market. The relatively lower amount of frictions in the market might have allowed quantities to more quickly rise to meet demand, even as average prices would have remained lower without the mortgage deduction. Landlord buyers would have been able to build large numbers of homes at prices they could profit from. With the mortgage tax deduction, home builders could hold out for price levels higher than the landlord price level, but they had to find buyers one at a time from the owner-occupier market.

For many reasons, there has been a deluge of capital searching for low-risk investments, and the housing market served as a useful conduit for that capital. In a more landlord dominated market, there would have been a much more robust set of saving opportunities through real estate. There would have been a much larger industry of REITS and mutual funds placing investments in landlord institutions. Savers would have been able to utilize real estate to meet current savings demand without trying to stuff so much of it through the conduit of owner-occupiers and small-time real estate investors.

Put another way, the equilibrium price of houses is the Price to Rent ratio that creates a return equal to other investment opportunities (including non-financial considerations). In a normal real estate market, taking away the mortgage deduction means the average Price to Rent ratio will decrease. This will lead to more quantity supplied from landlord owners, and rents will decline. The declining level of rent, with a stable Price to Rent ratio, will mean that prices would decline further.

In addition to the lower prices this change would encourage, the mortgage market should allow low income households to establish ownership with few obstacles. Down payments should be low, and various payment options should be available. There is no reason to publicly subsidize these things. Anyone who does establish ownership will likely already be earning profits relative to renting households. Private mortgage insurance and securitization were available in the 2000's. There is no reason why we need to bring in the moral hazard problems of public subsidization. Deregulation would suffice. In effect, housing policy should be a policy of creating lower housing prices and then not encouraging households to be home owners.

The main problem with this prescription is that there will still remain this deep cultural association of home ownership with the middle class. As long as we have that association, on the margin, there will probably be households that establish a real estate position when they probably shouldn't. That would subside over time, and, in fact, may already be less of an issue after the collapse of 2008. Generally, the positive cash flows from mortgaged home ownership come after years of rent inflation, so there isn't generally a short-sighted incentive to switch from renting to owning.

So, please, take your mortgage interest deduction and give us back the real estate market of the 2000's. There may never be a better time to do it. This is what so-called consumer rights activists and working class political heroes should be pushing for. So, Who's with me?....I said, Who's with me?!.....

...I think I have one more post worth of this nonsense, for those of you still hanging with me....

Tuesday, December 23, 2014

This is an interesting period of time, coming out of QE3. Inflation expectations and real interest rates rose during the QEs, and then declined coming out of the QEs, and in hindsight, QE3 seems to have created the same basic pattern. Short term treasury rates are distorted by the curvature at the short end of the yield curve. This first chart is the 5 year, 5 year forward real interest rate (approx.) and expected inflation. This shows the tendency for both real rates and inflation expectations to have risen during QEs and fallen afterward. Long term real rates are lower now than after QE1 or QE2, even though it still appears as though a rate increase might happen.

All of the QEs stabilized the forward yield curve, bringing us closer to the point where short term rates might rise above the zero lower bound. The length of QE3 was helpful in this regard, since we are now back to within six months of the expected date of interest rate increases for the first time since the beginning of the crisis. (I think this is the case, but my data prior to QE3 isn't as precise, so I'm not certain.) With the pullback in October, it looked like the expected date of the first rate increase might start moving forward in time again. But, this has recovered, and as of Friday, the expected first rate increase was less than 6 months away for the first time in a long time.

QE3 seems to have improved near term expectations enough to firm expectations for the eventual rate increase, but at the same time, long term forward rates have declined. Here we can see the yield curve for Eurodollar futures over time during QE3. The time frame for rate hikes has remained fairly stable. By the end of 2013, the timing of the first hike had moved back somewhat, but most of the effect was to increase the slope of the yield curve after hikes began, and to increase the expected final level of rates after rate hikes would have ceased. The expected rate hike remains in mid-2015 now, but the slope of the yield curve is fairly flat again, and most strikingly, the long end of the curve has moved even lower than it had been at the start of QE3. This suggests that Fed Funds rates are expected to top out at around 2.5%. (Some of the Eurodollar rates after about 2017 would reflect the TED spread and a maturity premium over the expected future Fed Funds rate.)

Markets seem to expect that we will have a very hawkish Fed, but that we will escape the zero lower bound in spite of it.

We now have two countervailing forces working on inflation and interest rates. Commodities prices are in steep decline. The broad decline in dollar terms suggests a monetary source for this, although there may be some supply influences, also. So, this should be related to a decline in inflation along with some increase in real consumption. In the meantime, real estate prices are leveling out, which looks like it is mostly the result of less supply, due to credit market constraints (stagnant bank lending, which may soon improve) and the premature exit from QE3 (household leverage still too high). (edit: This is decreasing the supply of new homes, which is causing rent inflation.) This is increasing inflation at the expense of real incomes. But, since most households are also home owners, the negative effect of the housing supply problem on incomes may be muted. Beyond its effect on nominal incomes, I am not sure of the effect of the housing constraint on interest rates, since expanding mortgage markets will effect both investment supply and demand.

The next six months should lead to some important discoveries about the future path of the US economy. The Wizard of Oz theory of the Fed is not helpful here. Rates won't rise in mid-2015 just because the Fed decides that they will. If the Fed decides to hike rates inappropriately, the yield curve will flatten, and we will be in for a nasty ride. There will be no mistaking it. If forward rates remain elevated when the Fed starts to increase Interest on Reserves and the Fed Funds Rate, we will know that the US economy had enough momentum to expand while at the zero lower bound. Then the question will be whether the Fed manages the subsequent money supply in a way that keeps us off of the ZLB. I am not hopeful about that, since it probably necessitates an inflation target above 2%. But, it's a much better problem than the problem of never leaving the ZLB to begin with.

Wednesday, December 17, 2014

Recent trends continue. Core minus shelter (C-S) inflation turned negative again, so now we have deflation in 3 out of the 5 recent months, and basically no C-S inflation over the past 5 months, cumulatively. If mortgage credit markets can expand as a result of recent regulatory adjustments, then I expect a domino effect of rising home prices, rising new home production, declining rent inflation, and recovery in Core minus Shelter inflation to follow.

If mortgage credit markets remain stagnant, then I expect this pattern to continue, and the question will be whether wage stickiness has diminished enough and real natural interest rates have risen enough to stop hampering economic growth.

This is a complicated outcome. There will be shelter inflation, but much of that is simply an accounting transfer within households. Households will see rising nominal incomes, but those incomes won't rise as much in real terms because they will be spending much of the extra income on rent...to themselves. Since this is a transfer of income which doesn't involve any actual change in cash flows for home-owning households, it won't be a relevant issue regarding those households' economic decisions. (Except, since this issue arises from a stymied housing market, household estimates of their net worth will be somewhat lowered by the low real estate prices.)

So real incomes will be rising faster than they appear among home-owning households, but households that rent will see stagnating real incomes, as their nominal income gains will accrue to landlords. This is already happening, and we can see the market responses, one of which is a very strong multi-unit residential construction market, relative to single family homes. In this scenario, if RGDP is our jumping off point for measuring economic growth, then households and landlords will have additional real discretionary income equal to about 1% of RGDP, compared to the official measure. (This is because their imputed rent will rise due to rent inflation, which will be subtracted from nominal GDP growth.) Since this is, at its core, a product of lower real estate equity, it is essentially the same economic effect that we would see if homes rose in value and households pulled 1% of GDP out of growing home equity value and used it for household consumption. Except, in that case, the extra spending would be measured as NGDP growth. If the rising home prices were a product of wider access to real estate credit, then it would also be associated with rising RGDP, since new home building would ease rent inflation.

So, while I see this Core minus Shelter inflation as a bad sign, it is mostly as a sign of potentially catastrophic deflation. The odds of Fed policy becoming far too tight surely are higher in a context where most core spending is already deflationary.

But, if real wage growth rises, as it should with low unemployment rates, and if natural interest rates are above zero, as they should be in a mature recovery with low unemployment and solid NGDP growth, and if households, in effect, automatically are capturing and spending their real estate capital gains, inflation might not be as important as it is when NGDP, employment, and interest rates are plummeting.

I will look at some housing issues a bit more in the next post.

PS: Commenter TravisV sees inflation as more important in the near term, and while my review of the topic has led to several posts nibbling around the edges of this topic, I still need to put together a post looking at near term Fed policy scenarios more directly.

Tuesday, December 16, 2014

These charts from the New York Times are just the kind of thing I've been looking for.

Here is the static version of the chart from the article. It would be great to see a moving version of this over a longer period of time.

I'm not sure there is much to worry about on the age groups under 50 years. Some blame the increase in young workers not working while in school on the minimum wage. There might have been some of that after the 2007-2009 hikes, but the minimum wage is nearly back to insignificant levels, so I can't believe it would have had that much of an effect. And, we saw this same trend between the MW hikes of 1996 and 2007. So, I think this is largely a cultural shift.

Between 25 and 50 years, there has been a shift to unemployment, which is cyclical and should be generally temporary. Otherwise, there have been small shifts to disability and caring for family.

I would also attribute much of the drop in rates of retirement to cultural changes, generally from people being more productive and active at older ages. Some attribute this to older workers lacking retirement support, but as with the young, this represents a long term shift in behaviors that has persisted through business cycles. There is a tendency to negativity in some of these interpretations, so that lower labor force participation in 50 year olds is blamed on stagnation and higher labor force participation in 60 year olds is also blamed on stagnation.

The largest problem is the disability issue, which affects the over 50 age groups the most. This is clearly the product of bloat in a program that has devastating moral hazard issues, and it appears to be a significant input into the decline in US labor force participation compared to other nations over the past couple of decades. Other public programs have the problem of creating a high de facto marginal tax rate for the poorest households. But, this policy provides a meager support level and then explicitly directs recipients to self-identify as unproductive. Local news teams expose frauds on disability who are filmed playing in softball leagues, etc. This is trees and forests, people. We're the monsters that put them in that situation. (Of course, you could say the same for banks overleveraged on AAA securities.) I predict that this problem will not be a topic in the political theater associated with upcoming elections.

Monday, December 15, 2014

Maybe I'm just repeating myself, but I wanted to revisit my recent post about how low risk for equity is related to high compensation share. This is really the same idea I played around with before, when I described labor as having some of the characteristics of debt, in that equity owners earn a premium from both of these categories of inputs in exchange for accepting fluctuations in income. This risk trade would create a discount in the cost of labor. When risk premiums are high, labor would have to take a large discount and when risk premiums are low, labor would take less of a discount. Historical data on compensation, debt, and equity seems to broadly suggest support for the various interrelationships of interest rates and risk premiums.

Here is a graph that makes the relationship a little more clear than the graph from the recent post.

I have included rental income in compensation, because this is generally owner-occupied rent to homeowners, so it is income widely distributed among households, and its recent increases have pushed compensation down in a way that is unrelated to corporate capital income.

I am using the annual Equity Risk Premium (ERP) from Damodaran (not unlevered). We can see that there have been periods with generally high ERPs and periods with generally low ERPs. (It is inverted in the graph.) When ERPs have been low, compensation share has tended to rise. When ERPs have been high, compensation share has tended to fall.

As a reminder, here is the graph from the recent post. Note that the compensation share is coming out of the profit share. Profit shares are going up when compensation shares are going down, and vice versa. This could lead to a simplistic interpretation that labor and capital are locked in a fight for incomes, with gains for one coming at the other's expense. One thing that is so interesting about these topics is how very subtle changes in how we look at the data can flip the interpretation on its head.

If this was a story of simply fighting over shares of income, profit shares would decline when compensation increased, but we shouldn't expect ERPs to decline. We would expect profits to fall and valuations to fall along with them. What we find, instead, is that a fall in ERPs is the factor which coincides with rising compensation. In fact, equity prices were very strong in the late 1980s and late 1990s, when compensation was growing. Equity gains in the 1960's were lackluster. Here are corporate tax rates over the period, from the Flow of Funds report. There is no obvious pattern there. These periods span the Johnson, Reagan, and Clinton presidencies - three different eras of fiscal governance. But, these periods had something in common, which was that equity holders demanded less of a premium during these periods for holding equity instead of debt.

One other similarity is that the periods with low ERPs tend to have longer business cycles. There have been three recoveries that lasted the better part of a decade over the past 60 years, and they coincide with these three periods of low ERPs and increasing compensation shares. And, these periods had moderate inflation, generally in the 2%-4% range. The high ERP period in the 1970s coincided with high inflation, and the recent high ERP period has coincided with low inflation.

So, I propose that what we see is not simply a redistribution of income. It's more of a growth in risk-adjusted income, which is not easily measured with nominal dollars. The increase in compensation is a product of the lens through which equity holders view their income, which is as a premium on risk. When there is less risk, or at least less risk aversion, equity bids away less nominal income, leaving more for labor and debt. And, further, there is some evidence that a causal factor is stable aggregate demand.

Friday, December 12, 2014

Well, I said I'd look into it. But, actually, I don't think I have a reliable way to avoid adopting a vulgar pretense of principles.

Keynes famously said, "Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist." This really doesn't only apply to economists. I was reminded of this when I recently read this article about how John Muir's dismissive attitude toward Native Americans led to a lack of appreciation about how much some of the landscape he treasured had been managed by the indigenous people. From this false premise, an entire paradigm toward ecology was built. This article is what originally enticed me to write on this topic. But, then, after finishing the first post, I have to admit that the analogy I sometimes use to compare economic policy to environmental policy utilizes this very premise. Few people advocate meddling in the rainforest. Yet, the forests we know have been deeply altered by human management for centuries. So, I couldn't even complete the prequel to the post about intellectual honesty without accidentally promoting a point of view by using the misconceptions of its detractors.

What I was going to say, before I discredited myself, was that we all work out of some paradigm that consists of a set of interlocking presumptions. Each of those presumptions, we hold with some confidence. And, usually, if one presumption changes, it necessitates a change in the other presumptions. The problem is that if you have a set of, say, 12 independent beliefs, and you have 80% confidence in each of them, you are 93% likely to be wrong about your broad worldview. I am being wildly optimistic in saying that any of us holds less than 12 important beliefs that deserve an 80% confidence level. If you think that you have a better set of priors than that, I can promise that, at least for a topic as complex as finance, we could easily find many smart people that would concede to you less than 50% on that many of your beliefs.

Most of the time, we operate in the least useful context for improving this situation. We identify with groups of ideas or people that share a common set of beliefs. When one belief is tested, which would create dissonance among other related beliefs, we pull back to more generalism. We gather those other beliefs in defense of the belief that is being most directly tested. One easy way to do this is through ad hominem. We note that the source of the test has other beliefs that seem wrong, so that we can suspect that she has been misinformed in some way on the belief in question. Or, with a little extra work, the same sort of discounting can be applied to the idea itself. The fact that it contradicts several other beliefs creates doubt about the fact itself.

This is a very good reason to discount a new fact. It is also a guaranteed method for avoiding any movement toward accurate beliefs.

Avoiding this is very difficult, because engaging in it is part of the essence of being social and being human. I am frequently impressed by how Tyler Cowen can look at a source that might even treat him with contempt, and look for positive things to learn from it. It's something I try to mimic, but ranting about others from within our own paradigms is so much more viscerally fun, our motivation is always biased toward self-satisfaction.

The first step to combating this is to insist that instead of pulling out to more generalized levels, we push to more detail. We should look for ideas that test us and try to test the ideas on their own terms. This is difficult to do in broad conversation with those who are vastly different than us, because most of our detailed experience will be informed by vastly different priors, so the details will generally seem preposterous to us. For instance, in my previous post, Simon Wren-Lewis' statement that "the idea that private sector activity is always welfare enhancing and is best left alone was blown out of the water by the financial crisis" seemed like a ludicrous thing to say to me. It would be like describing "Dirty Dancing" as a morality tale. (Just goes to show you've got to clamp down on those teenage girls.) But, in most audiences, I'm sure Wren-Lewis' statement is wholly uncontroversial. Come to think of it, "Dirty Dancing" is a pretty effective morality tale. There's some dark stuff going on down at the servant's quarters, and Baby is getting pulled in over her head. But we all came in with the prior that you just don't put Baby in the corner, and priors rule our reaction to the movie. We might hope that we wouldn't be a jerk-wad about it, but of course we would stop our daughter from sleeping with Patrick Swayze at summer camp if we could. I mean, come on!

We take our reactions of outrage or incredulity as evidence of our own certitude, but frequently when we have extreme reactions, we are at our most unreliable. Extreme reactions may even be biology's tool for giving us a way to fool ourselves. My umbrage at Wren-Lewis' comment is a terrible reason to reject it, even if my umbrage is very convincing to me.

So, this should be our practice, considering ideas where there is some disconnect between our beliefs, or between theory and practice, or between our beliefs and other beliefs, and then dig down. This is usually easier on the margins than with someone coming from an entirely different direction. Usually, on my blog, I start with some sort of idea where a way of looking at something leads to a conclusion that is somehow counterintuitive to common treatment, and I'll follow it to where it goes. I usually start writing before I have looked at the data, to help organize my thoughts. Sometimes, like in this post on asset allocation, the data surprises me. The way the post is written probably gives the impression that I knew what I was doing. But, I had written the first half of the post, and was basically finished with a fairly standard description of the stock/bond relationship, when I thought, "Hmm, it wouldn't be that hard to check my data and see how close historical returns are to a normal distribution, just to double check this." And, I saw that bonds have a terrible distribution of long term returns, so I wrote the second half of the post and went on to do a series where I decided that there was a relationship between stocks, real estate, debt, and bonds that I hadn't fully appreciated before. I had noticed that the equity premium had not been historically consistent, but I hadn't considered the full ramifications.

But, surprisingly often, the data (or my interpretation of it) surprises me by agreeing with my hypothesis. On the 11 part series of posts about leverage and risk trading, I had an idea about how leverage would effect profit margins in a counterintuitive way. In thinking about it, it occurred to me that even though public discourse usually connects low interest rates to increased borrowing, the high margins I was trying to explain were coming from deleveraging in a low interest rate environment, and that even though this ran counter to common parlance, it was actually a corroboration of the Modigliani-Miller theory of taxed capital allocation. Anyway, I wrote the first post before I looked at any data, because it was just a hypothetical. It took me a long time to pull all the models together after that first post, and I was shocked at how much the historical data seemed to confirm the theory, because it just doesn't seem like it should work that way. (If true, it sure undermines any theory of the business cycle that assumes low bond rates are related to misallocated leveraged corporate investment.)

I also wasn't a housing bubble denier until I looked at the data. I saw a provocative post suggesting that there wasn't an excess construction of homes in the 2000s, and as I thought about it, I started thinking of homes as securities. (A friend tells me I turn everything into a bond.) As I ran the numbers, and thought about oddities that don't fit into the common narrative of the housing market, I concluded that home prices, given the low real long term interest rates we have seen, were not significantly out of line.

But, these descriptions of my work are still just narratives I tell myself. I've been rolling my eyes at Jonathon Gruber's transparent narratives, but in the end I don't know if his excuses are that different than my personal narratives. When I look back at how striking the data was on corporate leverage, my memory is just as clouded and self-serving as Gruber's is when he tells Congress that he can't remember what he was thinking, but it must have been XYZ. (XYZ happening to support a description of the law that would argue for Supreme Court support). Maybe the raw data doesn't support Modigliani-Miller at all, but I'm as good at making narratives from the data as I am at making narratives about how objectively I interpreted it.

I would like to say that finance makes us much more honest than, say, politics, because our mistakes lead directly to personal costs. But, a lot of financial analysis seems pretty flaky to me. Of course there are still agency issues in many cases. But, few things motivate us to backfill a narrative more than knowing we blew money on an investment or lost hard earned cash because of poor trading. This is why I generally assume relative efficiency in arbitrageable markets, but in many cases I could (must) believe in Semi-Strong IMH (Inefficient Market Hypothesis). That's where I trade.

Slate Star Codex had a great post on this problem, and how it complicates all contentious scientific endeavors. In the end, it comes down to personal judgment. Of course, as Feynman says, "The first principle is that you must not fool yourself and you are the easiest person to fool."

The producers of "Dirty Dancing" could count on audiences universally leaving the theater saying, "Can you believe that mean dad tried to keep the street-wise itinerant dance instructor from sleeping with his naïve school-girl daughter?" That's pretty strong evidence of semi-strong IMH (we are predictably, universally crazy in ways that we feel strongly about). But, then, if my reaction to Wren-Lewis is "Can you believe that mean economist tried to keep Wall Street banks from betting your savings on risky securities?" the only reason I can claim that my reaction is reasonable is because I'm backing up to generalities and then populating the narrative with a bunch of my personal judgment calls that are a product of my paradigm itself. Simply following different sets of seemingly reasonable priors very easily puts us in a position where even when we dig into the details and find something that clearly must be wrong, it will still be a product of the general.But, it's the best we can do, and it has to be our goal. Dig into those beliefs, and where we have 80% confidence, break down that confidence and test it, make that leg of our belief system fit a little awkwardly for a little bit. And, when new information comes in regarding the other legs, we might see that a little change over there helps the new leg fit a little better. Allowing a little dissonance to linger can lead to imperceptible paradigm shifts, until those shifts turn into a groundswell without us even noticing. (And, before you know it, you're sitting before Congress wondering what you possibly could have meant when you said the things you said. Which leads to another famous Keynes line: "If the facts change I change my mind, what do you do sir?" Even when looking back and seeing change in ourselves, can we tell the difference between growth and fecklessness, or between self-serving in-filling and brave readjustments?)Where finance is helpful is that it relieves the pressure of trying to convince others or win arguments. I really appreciate my readers who share their insights and reactions. I started blogging partly to have those conversations. But, if I'm working on a semi-strong IMH trade, I need the marginal investor to be on the other side. If semi-strong IMH is accurate, then the most persistently tradable incongruities arise from the truths that are right there to see, which we all disregard. I can only really blog about my work as long as it mostly leaves other investors unmoved. So, I'm trading notes with the world, but I don't necessarily want to convince you. I want you to convince me that I'm wrong before I go putting money on the line. Thinking that way really helps me to be more objective. Not that I can say that I am objectively more objective than anyone else, just more objective than what I would have been if I was desperate to convince.

PS. I apologize if these last two posts seem self-indulgent. I promise posts will follow with charts and graphs.

My first major problem with small state people is that they are not prepared to look at these items on their merits. Instead they have a blanket ideological distaste for all things to do with government.

Boudreaux frequently bemoans the tendency for supporters of state expansion to assume the pure execution of good intentions in public policy. There is some imperfection in free society. We have an idea of how we would like to fix that problem through the sausage-making apparatus of the state. Then a miracle occurs. Problem fixed.

Clearly we are all self-serving or tendentious to some degree - which I'm sure describes some more than others. I don't want to spend any time here describing the worst cases. Instead, I think it's worth thinking about what causes these differences in approach. Both Wren-Lewis and Boudreaux are asking for some cost-benefit analysis regarding state actions, but both see the other side as being derelict in this regard.

Boudreaux notes that those seeking state solutions to asymmetrical information, negative externalities, etc. in markets don't seem to address those problems in their proposed public solutions, even though principal-agency problems and many other issues present difficulties especially in the public realm. Wren-Lewis expresses the complaint from the other end of the spectrum that many participants in public debates simply dismiss state action, out of hand, seeming to assume the costs exceed the benefits.

I think the problem here stems from the fallacy of good intentions, or the bias toward design, and the difficulty we have of analyzing the value of emergent phenomena, ex ante. A state-solution is a solution from design. Visible costs and benefits are limited to the imaginations of the designers and observers. But, the unseen effects will tend to tilt negative. This is because the context in which the action will take place is already the product of some emergent order. This bias toward negative unintended consequences is something that, today, we universally notice in a context like ecology. It's funny how two hundred years ago, we didn't tend to notice this problem in ecology, but we did seem to accept it in human affairs, but these biases switched in the early 20th century.

The problem is the opposite for actions outside the state. Free societies and markets lead to complex interrelations that we almost entirely don't understand. We tend to only notice exceptions. An extreme example of this is the frustration we feel when, say, our smartphone isn't doing something quite the way we would like for it to. We should, objectively, feel awe beyond our capacity for emotion every time we look at our phones. The only reasonable thing to expect of our smartphones would be for them to cease to function. In contrast to Boudreaux's presumed miracles, they really are a miracle - a miracle a billion times more impressive than a pencil, which is itself a miracle beyond anyone's understanding.

The only way to understand an emergent system ex ante is through broad principles. So, while the benefits of state action will generally be contained within our imagination of those benefits when we propose them, the most important benefits of private actions will always be the benefits that exceed our imaginations. In public debates, both sides are simply failing to come to grips with the emergent portion of the potential outcomes. This is understandable. It is an impossible task.

For someone proposing private, emergent responses to a given constraint or problem, the honest description of the benefits is, "I couldn't begin to tell you what the benefits will be. Millions of people more motivated and skilled than I am will be working through voluntary cooperation on millions of solutions and improvements, and the most long-lasting versions of those improvements will exceed any appreciation or understanding I could possibly provide you now. And when they are implemented, they will be implemented with such ease that we won't notice there was even a problem - like when we walk into a modern grocery and it seems unremarkable that tens of thousands of items were grown around the world, packaged, and delivered, waiting there for just the time when we would want them." On the other hand, our fears about emergent phenomena are easy to quantify. The life we currently have is palpable, and the extent to which some part of it could be displaced or damaged is something we can understand and tally today.

That's a tough sell. It's basically what Wren-Lewis is describing - a bias against design and for emergence because of a principle. And, frankly, I don't know of a convincing way to distinguish a thoughtful version of this from a vulgar version. Wren-Lewis would agree with me that we should have a bias against bulldozing through the rainforest in the name of managing ecology. How can we come to some similar principle in human affairs that satisfies both the skeptic and the supporter of the state? It seems obvious to me that, as a start, we would move toward public regulation that is transparent and simple, minimizing the potential for unintended consequences or regulatory sclerosis. I doubt if there is much disagreement about that. In practice, though, this probably tends to look like deregulation, even when it would be more accurately described as safer, more effective regulation.

After the comment quoted above, Wren-Lewis continues:

The evidence that government is ‘always the problem’ is just not there. The idea that private sector activity is always welfare enhancing and is best left alone was blown out of the water by the financial crisis.

This is the bias for design and for good intentions (battling a strawman, no less). This comment, taken literally, is preposterous. Left alone? (There was a run on securities facilitated by quasi-public firms, rated by a legal oligopoly, so that they could be highly leveraged according to an arbitrary standard set by regulation and justified by mandatory public insurance? Just goes to show what happens when you try to leave 'em alone, I guess. Anything short of the NIRA is practically anarchy. We just need to find and fix those remaining areas of discretion.) In any situation, when things go wrong, it is natural to think that, if only someone had taken control, if only we had regulated this a little more closely, we could have stopped it. Is there any context where, when something goes wrong, there is a consensus for giving less power to the state? When BP creates a spill in the Gulf, we all know that the obvious response is to strengthen and fund state regulatory agencies overseeing their work. When the VA commits egregious lapses of care, we all know that the obvious response is to strengthen and fund the VA, so they can better do their work. I don't believe I heard anyone propose subsidizing the oil industry after the BP spill so they could better fund their safety protocols. The double standard here is extreme.

Or, consider the incredible outcome that the U.S. was the only major power not to sign on to the Kyoto Protocol, and yet, is the only country to have actually met the 2012 global goal for CO2 reduction. And, how did we meet it? Because of private fracking for natural gas. This clearly is an unintended positive externality resulting from decentralized economic activity. But, we naturally experience this as an "accident", because there was no intention, and in fact, there was no way to seriously propose this as an alternative to other CO2 mitigating plans, ex ante. So, we have the fact that the legal and cultural incentives for aggressive wildcatting in the U.S. are the most powerful force for CO2 reduction in the world right now, and yet there is no way for market advocates to claim this as a victory for emergent order. Imagine the shame we would feel if every nation that signed on to the Kyoto Protocol met the target, and only we had not. "We could have donesomething, and we didn't." But, now, we're just left with an accident. Luck. And it is just that.

We are conditioned by the scientific movement to look for falsifiability. In the search for things we can learn, falsifiability is very useful and important. Where we do our work, this is central. We find topics to concentrate our efforts on, and we find little details to test - something falsifiable that moves our understanding to a higher plane. But, our self-guided attention gives us a false sense of the pervasiveness of falsifiability. The fact is, there is no promise that the truth is falsifiable, and, in fact, in the range of true facts with the complexity of broad human endeavors, falsifiability is unlikely.

I think this is why libertarians tend to be fatalistic about direct political activity. Opponents demand falsifiability. Either our principles are misplaced anyway and we are wrong, or we have a strong point to make and it's simply not possible to make it convincingly. I know how it feels to be on the other side. I feel that way myself about much of the Austrian Business Cycle stuff - it's not convincing to me, even though I am drawn to much of the Austrian work on decentralized activity.

So, if a common understanding is not available with which to check ourselves, how do we keep ourselves from falling into a vulgar form of our principles? I'll look into that on the next post.

Wednesday, December 10, 2014

Here is the last graph from yesterday's post. I think this goes to the heart of the problem with discourse about national economic policy. People frequently fail to make a very important distinction. Capital does not search for maximum profit. Capital searches for maximum risk-adjusted profit.

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Be careful. The scales differ on the two vertical axes.

We have the argument about viewing the economy as a fixed pie vs. viewing it dynamically, so that instead of fighting over shares at a given time, we should work to increase the rate of growth. And that's a good argument to have. And, lowering risk will arguably lead to higher growth. But, there is a more subtle and powerful point to be made here.

Capital is foundationally deferred consumption. Returns to capital don't reflect simply the added value to production at a point in time. They reflect cash flows over time. They reflect the premium to deferred consumption. The level of profits in an economy reflect a numerator and a denominator. And, the operator in the denominator is risk.

If risk premiums decline, risk-adjusted profits will be higher, all else equal. And, the way this shows up in national shares is that the share of domestic production claimed by capital declines as competitive pressures push the equilibrium returns down to their risk adjusted equilibrium level. When the premium for taking risk declines, income to capital at risk declines, and the income retained by less risky factors (labor and debt holders) increases.

This is what we see in the graph in the three long recoveries (1960s, 1980s, and 1990s) where the business cycle was able to continue expanding for several years after equilibriums were re-established from recovering profits coming out of the preceding recessions. As the long recoveries aged, risk premiums declined, and more income went to labor and debt - especially to labor. (Interest income was relatively flat in the late 1980's, but it was pushing against the downward trend that resulted from sharply decreasing inflation rates.)

On the other hand, here is the result we see to changing corporate tax rates over time. Effective domestic corporate tax rates have declined from about 50% to about 30% over the past 60 years or so. Note how corporate profits before taxes have fallen over this time, leaving corporate profits after tax relatively level.

I don't want to over-sell this. As I've discussed, this is only a portion of returns to capital, so the level of this share is somewhat dependent on the arbitrary distinctions of corporate vs. non-corporate profit and returns to debt vs. returns to equity. (Corporate debt has a tax advantage over equity. So, we should expect some increase in profits as corporate taxes decline simply because firms have less incentive to use debt in their capital structures. More operating profit would be allocated to net profit for equity holders. So, we should expect some increase in corporate profits, even if corporations don't bear the tax.) But, all else equal, if corporate taxes actually fell to corporations, profits would be on the order of 50% higher today than they are because of falling corporate tax rates.

It's such a shame that our public debates revolve around matters such as taxation which have such little long-term effect over time in areas where financial arbitrage is operative, and which involve clear costs. On the other hand, when capital's risk is reduced, profit shares decline. There is no mitigating factor here. Is there somebody who is against that?....No?...Then what are we arguing about? It's about risk.

Morgan Warstler frequently points out at Scott Sumner's blog that one benefit of NGDP targeting is that by stabilizing nominal production, the effect of fiscal policies on real production will be highlighted. I think NGDP would also illuminate the effects of national policies on risk. Most of the movement of income shares now is the result of moving into and out of equilibrium as we move through demand fluctuations of the business cycle. If demand fluctuations can be minimized, then changes over time to capital return behaviors will be more clearly the product of changes in risk perception, risk aversion, and the related level of real interest rates.

I have posited that low home prices are also keeping compensation shares down. About half of the decline from 1970s levels of compensation share has gone to corporate capital and about half to excess gains to home ownership. The shift to corporate capital happened during the volatile 1970s and early 1980s. Total corporate shares (profit + interest) have been level since 1985. The drop in compensation from the bottom in 1985 has substantially all gone to homeowners. (In the first graph, Net Operating Surplus includes all returns to capital, including rental income attributed to homeowners.) If monetary accommodation leads to rising real estate values, this should also boost compensation shares. And, if NGDP level targeting meant that the Fed stopped worrying about real estate prices, that would be another great side benefit of the policy.

Tuesday, December 9, 2014

JOLTS data continues to signal strength in the labor market. As with the regular employment data, this probably will be less important in the near term. Strength in the labor market seems persistent, and at the top of the cyclical range. Now it is just a matter of remaining in this range. Eventually, JOLTS might be an early signal of a cyclical downturn, but that seems to be a distant issue for the time being.

Hires, openings, and quits continue to accelerate. Not only the levels, but the trend growth rates are as strong as they have been in this recovery. We should be very optimistic about near term real economic growth.

Openings per unemployed worker continues to recover. I think the Beveridge Curve will continue to persist with this rightward shift, partly as a result of persistence in the inflated unemployment rate, and partly because of a higher openings rate, related to the aging labor force. An older labor force should also tend toward a lower unemployment rate, so if we can manage to extend this recovery for another five years and work off the persistent cyclical unemployment, this relationship might move back to the previous trend.

The next graph demonstrates some of these labor force changes (some of which are simply demographic). We can see that, compared to the early 2000's, the Quits Rate has declined relative to the Job Openings Rate. Older workers tend to have a lower Quits Rate, so this shift will probably remain in place for some time, and then begin to shift back as baby boomers retire.

In general, these shifts appear to be relatively mild in the historical context. Here is a long term graph of the Beveridge Curve from the San Francisco Federal Reserve Bank. We are still in the general range of the 60s, 90s and 2000s, well left of the 70s and 80s. (Openings are currently at 3.3%, unemployment at 5.8%.)

Generally, I think we tend to think of this relationship as shifting from left to right, so we think of rightward shifts as bad, since they are related to higher unemployment. But, I think the relationship may be more subtle than that. A higher Openings Rate should lead to a faster employment recovery rate.

So, we see the shift right in the 1970s and 1980s, and we might relate this to employment frictions. And there may be some truth to this. But, we could also view that period as having shifted upward. The higher relative Openings Rate may have helped to bring faster recoveries. That suggests fewer cyclical frictions. Possibly this is related to the slower rates of recovery in the past three cycles. On the other hand, openings were relatively low in the 1950's, and cyclical recoveries were very fast in that decade.

Risk Premiums, Real Growth, and Inflation
I wish there wasn't such a perception about strong labor markets leading to inflationary pressures. This seems to be a false notion, coming out of a narrative-based interpretation of labor markets. Strong quits and openings suggest a safe context for job searching among the labor force. In effect, this is the sign of a low risk premium for labor, which I would expect to run parallel with the risk premium for equity. This should lead to greater risk-taking - both through more innovative investments and through more churn in labor markets. The strongest effect of this risk taking should be higher real economic growth.

Some of the inflation narrative may come from a misinterpretation of the relative level of wages and profits. In a low risk context, risk premiums will decline and interest rates will rise. This will be related to higher leverage. Even if returns to capital remain level, the higher leverage will cause more of the capital returns to be allocated to debt (interest). Profit margins will decline as a result of this leverage, but this is an arbitrary distinction with regard to income shares.

We tend to talk about debt as the result of careless or greedy consumers and speculators. But, the movement in equilibrium debt levels is the product of much more subtle effects from these changing risk premiums.

We need to rid ourselves of this notion that investors and corporations are a teeming throng of capital-bearing zombies, mindlessly bidding up assets with an insatiable and unsustainable lust for profit. And, we need to rid ourselves of this notion that labor and capital are defined by a bidding war for a fixed pie of production.

In the three modern examples of extended, decade long recoveries, the mature portion of those recoveries (the late 60s, late 80s and late 90s) are associated with rising compensation, rising interest income, and declining profit shares. These are the signs of an economy with low risk aversion and lower frictions to real growth. Those who push for a manipulated end to the recovery because of financial stability concerns or because of concerns about wage inflation are needlessly hampering our shared abundance.

Commenter TravisV might want us to look at the late 1960s (see graph below). This is the period where the Fed began to err on the side of higher inflation. Look at compensation during that period. If the Fed doesn't decide it has to kneecap the recovery, this is what we could have. Surely we can manage this without going all the way to 10% inflation. But, if the Fed prefers another demand shock to even 4% inflation, which appears to be the case, then this positive outcome seems unlikely.

Misplaced emphasis on interest rates and inflation creates confusion here. It isn't so much the inflation itself that would lead to this sort of recovery. It's the lowered risk of an NGDP shock, which then lowers risk premiums. Persistently accommodative Fed policy will lower profit shares, and we will all be fat and happy. There is no reason for divisiveness on this matter. Political factions are unified in accepting false premises over which to argue, when no argument is necessary at all.

There doesn't even need to be a supply side vs. demand side argument. Long economic expansions clearly lead to falling profit shares. Call it "trickle down" if you like, but labor clearly benefits over time from a healthy corporate sector. And, how do we get there? Demand side stability. I'm ok, you're ok. Can we stop fighting over false premises? (Here's a follow up.)

Monday, December 8, 2014

As I said Friday, the trend will probably start to level out in unemployment, making this indicator less informative for macro-forecasting. The unemployment rate came in a little high this month, so there will probably be some decline off this level in the near term. But, I think we are likely to see a kink here to more level trends until the next downturn. Let's hope that is a way off. There is no sign of an imminent downturn in the productive economy.

Durations are probably settled into long term ranges. I expect durations under 26 weeks to move sideways from here. It is looking more and more like there will be some persistence in the various groups of long term unemployed, so December will be closer to 5.7% than to 5.5%, and the trend looks like it might flatten. Early in the year, I had hoped to see the quarterly exit rate of long term unemployed workers (this graph uses workers over 15 weeks) go over 40% and stay there. It will get there, but the rate has not increased as strongly as I'd hoped.

I am also starting to see a sustained leveling of the very long term unemployed, suggesting that this portion of measured unemployment may have some persistence. This is corroborated by the average duration data. By using the average duration data published by the BLS and estimating the average duration of workers unemployed for less than 26 weeks, we can also estimate the average duration of workers unemployed for more than 26 weeks. This is currently divided about half and half between regular unemployment and the unusual group of very long term unemployed. We can presume that the regular group of unemployed workers with durations over 26 weeks has an average duration of about 60 weeks (the well established range before 2009). We can further infer that the remaining unusual group has an average duration of more than 100 weeks. The average duration of workers unemployed for more than 26 weeks has remained around 80 weeks throughout the recovery, and jumped to 87 weeks this month, suggesting that the reductions in long term unemployment are coming from the regular group instead of the very long term group, and/or the average duration of the unusually long term group is continuing to age as time passes.

As I have mentioned, insured unemployment is a big reason why I still see some room for a drop of a couple tenths in the near term. Insured unemployment continues to fall sharply, and there is no historical precedent for a stagnating unemployment rate when insured unemployment continues to fall. We should expect to see a leveling of insured unemployment, after which, total unemployment will continue to fall slowly as the recovery ages. If insured unemployment continues to fall, then the trend in unemployment won't level off as quickly as I expect. Demographics could put the nadir of insured unemployment at a lower level than it has been in the past (baby boomers, messing with every statistic these days), but it probably is at a place where further declines will come more slowly. In any case, since total unemployment this month went against the trend suggested by insured unemployment, I expect to see some snap-back next month. 5.8% seems high.

Another reason to expect a snap back is flows. They all continue to trend toward recovery levels. The flow from Employed to Unemployed (EtoU) popped up to 1.3% this month. At this point, the EtoU flow should be in the 1.1%-1.2% range, and it has been for a while. If it had been in the expected range, this month would have come in at 7.6%-7.7%. The move up will certainly be reversed in coming months. There is typically a net flow between E and U of about 0.2%. This month there was very little net flow from unemployment into employment, which clearly is not reflective of the employment market. These are very noisy series, and the EtoU flow has been especially noisy while these flows have been elevated.

Wages continue to grow, albeit somewhat slowly. I attribute this mostly to low inflation. Wage growth has been unusually high during the recession. Now, even if, as I suspect, labor markets are more reflective of 5% than 6% unemployment, real wage growth of just under 1% is not out of the ordinary. Back in 2009, when real wages were growing at 2% and unemployment was over 8% - that was out of the ordinary, and it was a problem.

I had been positioning for rising long term interest rates over the past 1-2 years because of QE3 and the end of EUI, which I expected to push up inflation and pull down unemployment, relative to expectations, pulling back the date of the first rate hike. Forward rates did rise a bit, more from a steepening of the yield curve than from a movement of the first rate rise. The inflation never really materialized. So, the date of the first hike remains about where it was 2 years ago. (This, itself, is a huge win compared to pre-QE3 Fed policy, which had seen the expected rate hike continually moving forward in time, like a carrot on a stick.)

As QE3 tapered, mortgage credit failed to break out, and so over the course of 2014, I believe that limits to credit growth have overtaken improvements in the labor market as the critical element for forward rate increases. As we move into 2015, I believe that mortgage credit will be a more important signal for interest rates than employment, and much of the change in forward rates, if credit market expansion grows, will come from a steepening yield curve.

While all the moving parts in the Federal Reserve balance sheet make this difficult to forecast, it seems likely to me that the yield curve will either flatten in a worst case scenario, or rates will increase at a rate of 2-4% per year, as they have in past episodes. Right now, the yield curve suggests a rise of about 1% per year. So, I expect there to be a speculative opportunity here.

I was beginning to worry that the expected date of the rate hike was starting to move forward again as we move away from QE3. But, after the November employment report, the large increase in rates was almost entirely the result of a move back in time of the expected first rate hike of about 1 1/2 months (to approx. the end of 2015 2Q), where it had been before October and right where it had been at the beginning of QE3. This last graph shows the movement of forward Eurodollar rates since the beginning of QE3. The short end of the curve is almost exactly where it was a year ago. At the long end, terminal rates have dropped by about 1.5% over the past year, back to where they were at the start of QE3.

My "expected" rate trajectory accepts the market's expected first rate hike, but follows a rate of 1.5% of hikes per year. Even this is a much slower rise than past episodes of rate increases.

Friday, December 5, 2014

The scatterplot of unemployment with insured unemployment gives visual evidence of the persistence of unemployment and the long term damage done by labor disruptions. Here is the plot since 1971, first in raw monthly numbers, then in trailing 12 month moving averages.

We can see that unemployment remains elevated after each event. Unemployment was relatively low during the 1975 disruption. But, the recovery only lasted 5 years. When the next disruption hit in 1980, unemployment was still elevated. Then, the labor market was disrupted again in 1982, and unemployment, relative to insured unemployment, rose far from the normal range. The labor market stalled in 1985-1986, but a full-scale disruption was avoided, so relative unemployment continued to slowly decline over time.

The next disruption happened in 1992, after a full 10 years of recovery, so the relative level of unemployment had fallen back into the normal range, but was still high. The following recovery was 11 years long, so that by 2003, the level of unemployment, relative to insured unemployment, had fallen to below the level of the early 1970's.

Normal UE = total UE predicted by short term UE

Then, I think we see two things going on in the disruption of 2009. First, since the recovery was only 6 years long, relative unemployment hadn't fallen back to its 2003 level, so the level of unemployment was slightly higher than the trajectory it followed in 2003. Second, pro-cyclical policies - mainly very long-term unemployment insurance - led to an unusual number of reported very long-term unemployed persons. We can see this in the third graph, where the level of total unemployment is reliably predicted by short term unemployment until the recent disruption.

At this point, the excess unemployment, relative to insured unemployment, is roughly divided in half. Half of it could be related to the shortened business cycle that has led to a persistent increase in uninsured unemployment, similar to the 1980s, which appears to slowly decline as the business cycle lengthens. The other half appears to be related to the unique feature of very long-term unemployment, regarding which there is no American precedent with which to anchor our expectations.

Given these factors, and given that exit rates from short and medium term unemployment should now be unaffected by EUI policies, monthly employment reports will have somewhat less importance, going forward. Regular unemployment is roughly 5.0% now, and should slowly decline to 4.0% or even less if we can manage to maintain the recovery for another, say, 5 years. The other approx. 0.8% of reported unemployment is very long term, and presumably marginally attached to the labor force. While it's decline has been fairly linear for 2 to 3 years, at a rate that would burn it off by early 2016, its further decline and the destination of the workers who are leaving the category, may be difficult to track and may be only tangentially related to other factors at work in the economy.

Thursday, December 4, 2014

Following on my earlier post, where I propose that the lack of reliable excess returns is not that dependent on efficiency, here is a short hand for levels of market efficiency. These are roughly in order from contexts with the least amount of available excess returns to contexts with the most available excess returns.:

Strong EMH (prices reflect all public and private information)

Nobody can earn excess returns.

Semi-Strong EMH (prices reflect all public information)

Only insiders can earn excess returns.

Weak EMH (prices are independent of past prices)

Excess returns without inside information are possible, but aren't persistent.

Weak IMH (investors are occasionally nearly universally unreasonable)

Persistent non-insider excess returns are only available in the (unlikely) event that you aren't bonkers.

Semi-Strong IMH (there are occasionally broad social pressures against being reasonable)

Persistent non-insider excess returns are available if you are willing to be frequently embarrassed and demonized.

Strong IMH (legal enforcement of inefficiency)

Persistent non-insider excess returns are available where there are an insufficient number of unregulated potential marginal investors.

In practice, strong IMH is widely available, but vulnerable to regulatory shocks. Semi-strong IMH is widely available, but requires a decent amount of skill and clinical depression. Weak IMH and weak EMH are difficult to distinguish from one another in practice. Most punditry, including my own, and trading is from the presumed point of view of Weak IMH, but in hindsight is usually a confirmation of Weak or Semi-Strong EMH. Even where investors, like Warren Buffett or Charlie Munger, spend a lifetime operating in something that looks like Weak IMH, there isn't enough evidence to clearly settle the issue. Of course, if IMH is operative, who would we depend on to confirm it?